The jump that wasn't

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Sep 7th 2008
From Economist.com

Corporate profits and the American stockmarket


AS corporate profits go, so goes the American stockmarket. But the profits picture is very confused at the moment—one reason, no doubt, why the market has been so volatile.

Three contradictory factors are at work. The first is the massive decline in financial sector profits, prompted by write-downs in the values of mortgage-related securities. The second and third factors are offsetting that huge blow. Energy profits have been boosted by the strength of the oil price, and the profits of companies with overseas subsidiaries have been boosted by the weak dollar and the relative strength of the global economy. According to Martin Barnes of the Bank Credit Analyst (BCA), overseas profits have increased for 22 consecutive quarters.

These factors are now set to reverse. Financial profits will inevitably rally strongly, as some of the write-offs drop out of the annual comparison. (There will undoubtedly be more credit-related losses but the write-offs over the last year have been exceptionally large.) The oil price has fallen by around $40 a barrel from its peak. The dollar has rallied strongly against the euro and the pound, in part because the global economy appears to be weakening.

BCA points out that most American direct investment has been in the developed world, with Europe accounting for more than 50% of the total and Asia (excluding Japan) less than 10%. In terms of earnings on this investment, Europe is just below 50% and the whole of the developed world around 60%. A further 9% of profits come from the Caribbean, where hedge funds and other offshore entities are based; these earnings are highly volatile.

If the global growth in industrial production slows from 4.5% to 2% next year, BCA reckons that the annual growth rate of overseas profits will slow from 21% (in this year’s first quarter) to 2.5% in 2009. And that is not allowing for any gain in the dollar, which will only make matters worse. Meanwhile, domestic profits are really struggling; according to Albert Edwards of Société Générale, the second quarter national accounts numbers showed a 17.5% year-on-year decline in the non-financial numbers.

Analysts’ forecasts for 34% corporate profits growth in 2009 are heavily influenced by the rebound in the financial sector (where earnings are expected to quadruple). But even if you take the financial sector out of the equation, pretty much every other industry is expected to deliver double-digit earnings growth and that sounds completely implausible. David Rosenberg of Merrill Lynch points out that the profits-to-GDP ratio peaked in this cycle at 14% and has since fallen to 12%; the typical recession trough is around 7%.

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In Europe, Ian Harnett of Absolute Strategy Research says that margins (defined as earnings before interest and tax as a proportion of sales) peaked at 12.7% in this cycle and are forecast by analysts to rise again to 13.2% next year. Given the economic trends, he thinks it is more likely that margins will drop to 8%.

Of course, it is only fair to point out that most investors don’t believe in analysts’ forecasts. Analysts may not really believe in them either; the reason for the big jump may be that they have adjusted their 2008 numbers downwards but not touched the 2009 figure. Nevertheless, it is usually hard for the stockmarket to make substantial progress when individual company forecasts are being revised dramatically lower, as they probably will be late this year and early in 2009.